The Return of Volatility

Over the past week, it is an understatement to say that “volatility has returned”. With the major U.S. indices facing correction territory (10% drop from recent highs at mid-day Tuesday), investors are being reminded that the type of equity markets we experienced over the the past year is the exception (higher returns, low volatility). And the speed with which this reminder ocurred (S&P down 7% in two days) can leave investors feeling very unnerved.

If the economic news is generally good, why is this happening? and what should we do in response?

There are several factors influencing the market, some fundamental, some not.

Rising Interest Rates/The Fed: Unlike 2015 when U.S. economic growth was tepid (at best) and international economies were still finding their post-2008 footing, the global economy has markedly improved, and current forecasts are predicting higher growth. Just last week, the January non-farm payroll number came in higher than expected. More importantly, hourly wages also saw an increase, providing the inflationary signal the Fed was seeking to accelerate their interest rate hikes. Equity markets may be reacting to the perceived end of this historical low rate environment and a concern over the Fed’s ability to manage inflation, should it wake from its recent slumber.

“Fear of Missing Out”: Given the length of this “high return/low volatility” environment, investors who spent much of the recovery on the sidelines may have capitulated and (re)entered the markets...giving in to the “Fear of Missing Out”. They may have quickly sold as market turbulence reemerged. The same dynamic may be in play as it relates to passive investing strategies. Investors who invested in passive vehicles at a record pace in 2017 may be re-thinking that approach.

Program Trading: As the various indices drop to certain pre-determined levels, automatic sell orders are engaged, driving prices even lower. The financial press reports that orders derived from algorithmic trading swelled at various points during the day Tuesday, bringing amplified volatility.

What should we do?

To our clients, this answer will be familiar. We prepare for this type of volatility at the outset of the relationship…by assessing client risk, constructing a portfolio commensurate with their risk profile, and enforcing a disciplined approach when implementing the strategy. That discipline includes rebalancing back to target weightings for each asset class. This involves reducing equity exposure in up markets or increasing back to targets in down markets.

To quote Roger Daltry, “Meet the New Boss…Same as the Old Boss”. Volatility has been and always will be a vital part of the investment landscape, and the last few days have reminded us of the fundamental concept that investing involves some level of risk. Volatility improves the long term health of the market, helping deflate bubbles before they become too severe by exposing investors with little or no understanding of their risk profile. The type of market conditions we experienced in 2017 are the anomaly, and serious investors implement strategies in anticipation of more traditional market behavior.

BOTTOM LINE

At one level, much of this seems like an emotional overreaction. It is based on fear in the absence of any real evidence to support the concern. Inflation remains low, corporate earnings continue to grow, and the leading economic indicators continue moving higher. Until we see evidence that inflation is out of control, or that the economy is rolling over, there is nothing concrete to back up this fear.

That said, we have long anticipated what markets will do as the Fed normalizes rates, and we are finally getting a perspective. Bonds and stocks have moved in the same direction in recent memory, which is not typical. As long as rates stay within a reasonable level of expectations, we suspect stocks should generally perform well.

The good news in this pullback is that market valuations have dropped to more reasonable levels, particularly when looking at the price/earnings ratio of the S&P 500. When assessing the PE ratio based on the expected earnings for 2018, we are back near the historical average level for the S&P 500. This is a result of the reduction in stock price and the healthy earnings growth projected this year.

The market movement of the past few days is a healthy reminder that stock market returns never follow a straight line higher for very long. If you forget this lesson, it will usually lead to disappointment and frustration. The strong returns and low volatility of the past 18 months were an aberration to the time tested reality that the stock market is filled with short-term risk and volatility. If you invest in stocks, it is critical to maintain a long-term perspective in order to ride through the rough patches.